Beyond Bulls & Bears

Infrastructure Investment: A Tale of New CitiesOctober 19, 2012

In the developed world, we tend to take infrastructure for granted, noticing it only when it fails us or when images of far-away places remind us that not everyone enjoys electricity and hot water on demand. Infrastructure may not be the most glamorous investment sector, but as the foundation of globally expanding modern living standards, it’s certainly not a fad. It’s essential for powering our modern lives and businesses. Joyce Shapiro, Franklin Templeton Real Asset Advisors’ managing director of infrastructure and real resources, might be biased, but she feels this often-overlooked area should be demanding greater global attention from governments and investors.

Changing demographics, governmental fiscal distress, and growing scarcity of goods and services are some of the factors driving the need for more infrastructure spending. Estimates from the Organisation for Economic Co-operation and Development (OECD) suggest that nearly $50 trillion in infrastructure investment will be required between now and 2030, which includes over $3 trillion of expected electricity infrastructure investment in Asia alone1.

Population growth, particularly in emerging economies, is also expected to fuel demand for real resources over the coming decades, a scenario which leads Shapiro to think infrastructure as an asset class has an exciting future.[php function = 1]

“Not only is there a rapidly growing need for new and/or improved infrastructure in both developed and emerging markets, but also real and growing investor appetite for these assets. Institutional investors in particular seem to be realizing the potential benefits of this asset class and its natural fit in their portfolio mix. Despite a slowdown in infrastructure investment in recent years due to the global economic crisis, we have seen an influx of infrastructure deals that will likely continue. At the same time, the number and size of private infrastructure funds have grown dramatically in the past five years, in tandem with institutional investors’ increasing interest in accessing the sector directly.

Infrastructure and real resources investments generally represent essential goods and services with relatively inelastic demand, long economic lives, correlation with inflation or GDP, and a natural monopoly or protected market. These characteristics have the potential to translate into investment portfolio benefits.”

Ways to Invest

Investors can access infrastructure and real resources investments through both public and private markets, but not all opportunities are created alike. Publicly traded infrastructure funds may not offer adequate diversification, as they historically provide significant exposure to utilities, social infrastructure and telecommunications, and are subject to the volatility of public markets. Similarly, investing directly in an infrastructure-related company, such as a construction and engineering firm, may not necessarily represent a pure-play on the asset class. Shapiro believes an active management approach has the potential to provide the benefits of both worlds.

“As private market investors, we believe that investing alongside local operating partners with sector-specific expertise may provide the most attractive risk-adjusted returns. Exploring the interconnectivities between the various infrastructure and real resources sectors may also lead to more efficient capital placement. Ultimately, I believe that investors seeking high risk-adjusted returns from their infrastructure and real resources investments should consider a strategy that seeks diversification across geographies, sectors, revenue models and stage of investment.”

Emerging markets such as China, India and Brazil have continued to invest in roads, airports and rail networks as their economies advance. You can see in the chart below how anticipated growth in China’s mega-cities could potentially result in even more infrastructure spending there. Even in developed markets, much of the existing infrastructure has been in place for several decades and is nearing the end of its useful life, providing new investment opportunities as such facilities are updated, sometimes with a combination of private and public sector investment.

“The construct of a public-private partnership as a result of some of the macro trends and fiscal stress governments around the world are experiencing in terms of finding the capital to support finance and operate these types of assets, brings the private sector an opportunity to partner with the public sector in a meaningful way. For example, in India, we’ve had news of about nine different roads that have been approved for private capital to come into these projects to sit alongside government capital. Depending on where we look and what’s motivating the governments, we have the opportunity to participate alongside the governments in contractive revenue streams. We are seeing a migration of opportunities to move to the private sector to replace some of the public sectors responsibility in these sectors.”

Shapiro says the energy sector alone offers an enormous range of potential opportunities for infrastructure investors, from transportation and storage of traditional energy sources like oil and gas, to renewable energy projects such as wind and solar farms.

“Thanks to the recent shale gas boom, the U.S. is now a net exporter of liquid gas. Utilities such as water, gas and electricity networks also provide interesting opportunities.”

Infrastructure spans a huge range of asset types, and this diversification is part of its investment appeal, in Shapiro’s view. But she says that’s just one reason to consider the sector.

“Infrastructure offers the potential to secure the much sought-after combination of low volatility and steady yield, which we believe makes it an increasingly important element of portfolio allocation. While we believe infrastructure offers a good risk/return model, like all investments there are risks to be managed. The demographic shifts involved with the rapid growth taking place in emerging markets are huge, and investing prudently in these markets is challenging. We believe it is important for investors to either conduct thorough due diligence on their own or employ a manager who is well positioned to do so.”

The idea of infrastructure as an area of private enterprise has taken hold to widely varying degrees in different regions around the world.Shapiro believes that understanding the stage of development infrastructure has achieved as a private business in a given region is as important as grasping the local nuances of each of the underlying sectors. The legal, political and economic forces that impact infrastructure are as vast and diverse as global regions themselves.

In short: infrastructure investments may well be a bridge to low volatility and steady yield, but it’s a strategy that can present its fair share of potholes, so you need to keep your eyes on the road, and have a knowledgeable driver at your disposal.

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What are the Risks?

All investments involve risks, including the possible loss of principal. Foreign investing, especially in emerging markets, involves additional risk such as currency and market volatility as well as political and social instability. Investments in infrastructure related projects are subject to various risks including governmental regulations, high interest costs associated with capital construction programs, costs associated with compliance and changes in environmental regulation, economic slowdown and surplus capacity, competition and other factors. Investment in non-US and emerging market projects is subject to currency fluctuations, and to economic and political risks associated with such foreign countries.

1. Source: Figures compiled by FTRAA for the period 2012-2030 based on estimated annual expenditures for the respective sectors as published by OECD. Sources: OECD (2012), Strategic Transport Infrastructure Needs to 2030, OECD Publishing, dx.doi.org/10.1787/9789264114425-en OECD (2006), Strategic Infrastructure to 2030: telecom, Land Transport, Water and Electricity, OECD Publishing, dx.doi.org/10.1787/9789264023994-en

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